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Annuity Risks & How to Reduce Them

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Mention annuities to someone preparing for retirement, and it is rarely received with a warm reaction.  Responses typically involve uttering comments such as “rip off”, “complicated”, “big commission”, or some similar characterization, usually in a not-so-subtle aversive tone. However, it has also been my experience that these same people are unable to describe an annuity, how they work, or the features they possess – their views are often shaped by the media, which has used half-truths to depict the act of purchasing an annuity as “annuicide”.

Well, I must admit that this response is indeed appropriate for some annuity products, and, in general, annuities do have characteristics that make them less attractive than other types of financial products (see the chart at the bottom of this article for a summary) – but this certainly does not negate the fact that annuities have useful features that make them an important part of a well-designed retirement income plan.

There are ways to reduce annuity risks, which are in face quite simple and straightforward, but first a brief discussion of some of the drawbacks of annuities.

Annuity Risks

I am going to focus my discussion on a particular subset of annuities, called “immediate annuities” – these are the old-fashioned type that give you a guaranteed paycheck for life.  While certain deferred annuities do have valuable protective features as well (and, I would argue, can be preferable to a pure systematic withdrawal strategy) , they require a different type of analysis that is beyond the scope of this article.

Now, immediate annuities have three particular draw backs in their design that make them unattractive to most people:

Illiquidity

First, they are illiquid – that is, you pour a bunch of money into these contracts when you purchase them, and cannot get this equity back (in other words, there is no “cash value”) other than through the future income benefits that you are promised.  This makes them very inflexible, and can be a problem if you have a need for additional cash.  While some immediate annuities have evolved to provide limited access to your equity in certain situations, they are not as accessible as savings in mutual funds or any other conventional type of investment vehicle.

Credit Risk

Because immediate annuities are contracts that are a promise made by a life insurance company that may span decades, there is concern about the possibility that the insurance company may become financially distressed and unable to fulfill its obligation.  The combination of a long time horizon and illiquidity make investors understandably nervous.

Bequest Risk

This issue has always fascinated me – it is often one of the first criticisms of immediate annuities, that if you die, your heirs lose out.  However, bequest needs are usually a very low priority for many retirees.  Nevertheless, it is still a very real disadvantage to other income strategies.

The “Gradual Annuitization” Alternative

To mitigate some of these negatives, I have championed the idea of gradual annuitization (also known as an “annuity ladder”) – that is, instead of plunking all of your savings into a single immediate annuity contract, you stagger your purchases over many years and gradually build up a guaranteed lifetime income benefit.

To illustrate how this would work, let’s look at a retiring man who is 65 years old with $1M.  If he pursued a systematic withdrawal strategy, the Fidelity Investments and Charles Schwabs would recommend he take $40,000 of income in his first year of retirement.  Alternatively, he could use the $1M to purchase a fixed immediate annuity from Pacific Life and get first year income of $52,288 that increases 3% per year thereafter.  Under a gradual annuitization strategy (identified by our planning technology, Nestor) he can budget $16K per year toward a variable immediate annuity and $14K per year toward longevity insurance, each year from age 65 to age 85, and get first year income of $42,047.   This “hybrid strategy” allows him to keep his $1M at the beginning of his retirement (unlike the full annuitization strategy) and, by age 85, have the guaranteed income backed by annuities that he will need to sustain this spending for the rest of his life (unlike the systematic withdrawal strategy, which is at risk of running out of money).

Because it is a hybrid, it has the advantages and disadvantages of both immediate annuities and systematic withdrawals, but to a lessor extent.

There is also a “form” advantage that gradual annuitization provides that, I believe, make it a much more palatable way for you to acquire income protection for retirement.  Most people are comfortable with the idea of including insurance as a part of their on going budget, and are not comfortable paying for lifetime protection with a single, huge premium.  Gradual annuitization overcomes this problem by allowing people to purchase this protection gradually as a part of their “insurance budget”.

One risk of a gradual annuitization strategy is that if your savings erode,  through investment losses and/or higher than anticipated spending, you may not have the money that will be necessary to secure the annuity income you need.

Nestor

We have incorporated the idea of gradual annuitization into our Nestor technology, and you will therefore see this incorporated into the recommended strategies that it provides.

Please read the following summary for a more comprehensive comparison of immediate annuitization, systematic withdrawals, and gradual annuitization.

 

Systematic Withdrawals

Immediate Annuitization

Gradual Annuitization, “Annuity Ladder”

Liquidity Risk

Assuming savings are invested in marketable securities, they can more easily be exchanged for cash.

Immediate annuities have no cash value.  It should be noted that this loss of liquidity does result in higher levels of income because insurance companies can invest in longer term assets.

Assuming savings are invested in marketable securities; they can more easily be exchanged for cash in early years of retirement, but becomes increasingly less liquid as immediate annuities are purchased.

Longevity Risk

Systematic withdrawals do not have an embedded mechanism to provide cost effective longevity protection; if you survive to the end of the planning period you are at high risk of being unable to meeting your income needs.

By pooling longevity risk, immediate annuities provide cost effective longevity protection, with insurance companies guaranteeing lifetime income.

As immediate annuities are purchased over the life of the program, longevity protection becomes secured (but at a higher cost than immediate annuitization); however if savings are eroded due to poor returns or high expenses, there is a risk that you may not secure a sufficient level of longevity protection.

Initial Level of Income

Systematic withdrawals are not able to produce a high level of initial income without increasing the risk of outliving your assets.

The pooling of longevity risk and illiquidity of immediate annuities enables them to generate higher levels of income than systematic withdrawals at a comparable risk level.

Annuity ladders can support higher levels of initial income than systematic withdrawals, but not as much as immediate annuities, at comparable risk levels, assuming the annuity ladder is implemented as planned.

Interest Rate Risk

Systematic withdrawals can be designed in a way to minimize interest rate risk through bond ladders or other structures that manage the timing of cash flow.

Fixed immediate annuities and longevity insurance are priced at a fixed and locked in rate of interest, which may be detrimental if interest rates increase.

Because we spread the purchase of annuities over a number of years, we can “dollar cost average” into interest rates and potentially benefit should interest rates increase.

Credit Risk

Credit risk can be managed through broad diversification or index investing.

Immediate annuities are highly dependent upon the claims paying ability of the insurance companies, and the illiquidity of these products precludes the ability to move these funds to another insurance company in the future.

By spreading annuity purchases over time, you can diversity credit risk by purchasing from several different insurance companies and can avoid making future annuity purchases from companies whose financial condition may be deteriorating.

 Flexibility

Assuming savings are invested in marketable securities, they can more easily be exchanged and redeployed if needed or desired.

Immediate annuities have no cash value and are non-transferrable to other insurance companies.

Initially, an annuity ladder has the same flexibility as a systematic withdrawal plan, and gives you more flexibility in terms of the annuities you can purchase than a plan of immediate annuitization.

Market Risk

The ability to meet long term income needs will be highly dependent upon market returns.

Fixed immediate annuities and longevity insurance have no market risk; variable immediate annuities are exposed to market risk, but the effect on long term income is less than under a comparable plan of systematic withdrawals.

Annuity ladders do have market risk exposure, and there is a risk that market losses on savings in the early years may diminish your ability to make annuity purchases in the future, but market risk over the planning period is less than under a systematic withdrawal plan.

Bequest Risk

If you die before reaching the end of your planning period, your heirs will receive whatever remaining savings you have at the time of your death.

Upon your death, immediate annuities will generally not have any remaining benefit left to heirs at any time (unless a period certain was elected and death occurs before the end of the period certain)

An annuity ladder has a bequest level that is very close to that of a systematic withdrawal plan in the early years, and declines as immediate annuities are purchased.  This risk can be mitigated somewhat by selecting an appropriate reserve savings amount.


Favorable

Unfavorable

Somewhat Favorable

Posted by

John Bevacqua on November 13, 2011

Filed Under

Income Strategies

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Because it is a hybrid, it has the advantages and disadvantages of both immediate annuities and systematic withdrawals, but to a lessor extent.


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